Italy's Derivatives Time Bomb Is Also Ticking

Financial markets are gripped by the role derivatives have played in Greece's debt crisis, but Italy also has a derivatives time bomb, and hundreds of cities are in the blast zone.

Many local governments eager to cut financing costs for years rushed to sign up for complex derivatives contracts, even when the terms were in English.

But some cities, facing big losses when interest rates go up, are now trying to pull out of derivatives and suing the international and local banks that arranged the deals.

In a test case, a judge in Milan will decide in coming weeks whether to try 13 people and four banks — UBS, Deutsche Bank, Germany's Depfa and JPMorgan Chase — on aggravated fraud charges.

The case stems from a derivatives swap over a 1.68 billion euro ($2.28 billion) 30-year bond, the biggest issued by an Italian city.

Milan, Italy's financial capital, is facing a 100 million euro loss on the deal, city officials say. Milan is also suing the banks for 239 million euros in overall liabilities.

In the southern region of Puglia, prosecutors are seeking to bar Merrill Lynch, a unit of Bank of America , from government contracts for two years.

The move stems from derivatives losses from 870 million euros in regional bonds. JPMorgan, UBS and Deutsche have denied wrongdoing, and Depfa has declined comment. Merrill has not commented.

Almost 500 small and large Italian cities are facing mark-to-market losses of 2.5 billion euros on the contracts, according to the Bank of Italy. Analysts say that figure will balloon when interest rates go up.

Most of the contracts involved switching fixed rates on loans to variable ones with banks.

"With the economic crisis, the problem has been lessened a bit (with lower rates) ... But in fact with a rate rise it becomes an even worse problem," said Fabio Amatucci, an expert on local government finances at Milan's Bocconi University.

The European Central Bank is expected to start hiking rates at the end of this year or early next year.

U.S. and European officials are looking into how U.S. investment bank Goldman Sachs Group Inc may have helped Greece disguise the size of its budget deficit through the use of cross-currency derivatives in 2001.

The Italian deals differ somewhat from the Greek case since the instruments were usually for switching rates on loans, but Italy stands out because of the vast number of cities, regions and public entities — even a theatre association — that turned to them from 2001 to 2008.

The Bank of Italy put the notional value of derivatives contracts at 24.1 billion euros in June 2009.

However, Il Sole 24 Ore business newspaper on Thursday cited Treasury data to put the overall figure at 35.5 billion euros — a third of local governments' debt — when wider criteria were used.

Although central bank figures show 467 local governments had derivatives contracts at the end of September, Amatucci believes the real number could be around 3,000 as more deals emerge.

The government banned new contracts in 2008 pending new rules.

Economy Minister Giulio Tremonti has said there is "no effect" from derivatives held by local governments.

Local governments rushed into derivatives in part because they helped ease the rigidity of a 2001 law that bars taking on new debt except to finance investment.

But another big draw was the upfront payment many cities got in advance for signing revamped agreements, usually done without a bidding process, analysts said.

Renegotiated deals shoved back payment and costs in a "political manipulation" of signings, said Giampaolo Gialazzo with the Tiche consultancy in Treviso.

Revised deals also carried increasingly restrictive terms and higher costs for municipalities and other local governments.

"Greece did nothing more than get itself money right away and then pay it back slowly. Local administrations in Italy did the same thing," said Massimiliano Palumbaro with CFI Advisors in Pescara.

Pescara, a southern Italian city, itself took out a total of 108 million euros in interest rate swaps and is suing UniCredit and BNL, a unit of France's BNP Paribas, over them. UniCredit had no comment, while BNL had no immediate comment.

When rates are low, as they were when many contracts were agreed, local authorities using a variable rate could find their costs shrinking. However, when rates rose, officials would find themselves owing more money.

Milan has argued, as have many other local administrations, that the contracts were murky, carried hidden costs and banks had failed to explain them.

However, a source close to the issue said Milan could not argue that it was ignorant about derivatives since the 2005 swap replaced a contract that had been renegotiated repeatedly.

The city also has wide securities markets experience given its joint control of listed utility A2A, the source said.

With banks putting in place a complex deal that had to be overseen for 30 years with hefty back-office costs, "the city could not expect that the banks were going to take that position for free," said the source.

Despite the court cases, Milan is still interested in derivatives. The city council said on Wednesday it was studying a switch from a variable rate on the contract to a fixed one.

Financial markets are gripped by the role derivatives have played in Greece's debt crisis, but Italy also has a derivatives time bomb, and hundreds of cities are in the blast zone.
Many local governments eager to cut financing costs for years rushed to sign up for complex...